Hedging Against the Government: A Solution to the Home Asset Bias Puzzle

This paper explains two puzzling facts: international nominal bonds and equity portfolios are biased domestically. In our two-country model, holding domestic nominal debt provides a hedge against price-level shocks and the impact on taxes they induce. For this result, only two features are essential: some nominal risk and taxes falling only on domestic agents. A third feature explains why agents choose to hold primarily domestic equity: government spending falls on domestic goods. Then, an increase in government spending raises the returns on domestic equity, providing a hedge against the subsequent increase in taxes. These conclusions are robust to the presence of in‡ation-indexed government debt, some tax revenues from foreign agents, and some government spending on foreign goods. Moreover, they are robust to a wide range of preference parameter values and the incompleteness of …nancial markets. A calibrated version of the model predicts asset holdings that quantitatively match the data.